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Saturday, February 16, 2019

Every so often the economies of the developed world malfunction, behaving in ways the economists’ theory says they shouldn’t. Economists fall to arguing among themselves about the causes of the breakdown and what should be done. We’re in such a period now.

It’s called “secular stagnation” and it’s characterised by weak growth – in the economy, in consumer spending, in business investment and in productivity improvement. This is accompanied by low price inflation and wage growth, and low real interest rates.

Let me warn you: the last time the advanced economies went haywire, it took the world’s economists about a decade to decide why their policies of managing the macro economy were no longer working and to reach consensus around a new policy approach.

That was in the mid-1970s, when the first OPEC oil-price shock brought to a head the problem of “stagflation” – high unemployment combined with high inflation – a problem the prevailing Keynesian orthodoxy said you couldn’t have.

The Keynesians’ “Phillips curve” said unemployment and inflation were logical opposites. If you had a lot of one, you wouldn’t have much of the other.

The developed world’s econocrats lost faith in Keynesianism and flirted with Milton Friedman’s “monetarism” – which was just a tarted-up version of the “neo-classical” orthodoxy that had prevailed until the Great Depression of the 1930s.

That was the previous time the economics profession fell to arguing among itself. Why? Because neo-classical economics said the Depression couldn’t happen, and had no solution to the slump bar the (counter-productive) notion that governments should balance their budgets.

It was John Maynard Keynes who, in his book The General Theory, published in 1936, explained what was wrong with neo-classical macro-economics, explained how the Depression had happened and advocated a solution: if the private sector wasn’t generating sufficient demand, the government should take its place by borrowing and spending.

In the period after World War II, almost all economists – and econocrats – became Keynesians. Until the advent of stagflation.

Notice a pattern? We start out with neo-classical thinking, then dump it for Keynesianism when it can’t explain the Depression. Then, when Keynesianism can’t explain stagflation, we dump it and revert to neo-classicism.

Enter Dr Mike Keating, a former top econocrat, who thinks the present crisis of stagnation means it’s time to dump neo-classicism and revert to Keynesianism.

Why do economists have rival theories and keep flipping between them? Because neither theory can explain every development in the economy, but both contain large elements of truth.

So it’s not so much a question of which theory is right, more a question of which is best at explaining and solving our present problem, as opposed to our last big problem.

I think there’s much to be said for this more eclectic, horses-for-courses approach. There’s no one right model. Rather, economists have a host of different models in their toolbox, and should pull out of the box the model that best fits the particular problem they’re dealing with.

And much is to be said for Keating’s argument that we need a different economic strategy to help us into the 21st century. Got a problem with stagnation? The tradesman you need to call is Keynes.

Although the rich economies are in a lot better shape than they were during the Depression – mainly because, in the global financial crisis of 2008, governments knew to apply Keynesian stimulus - Keating sees similarities between the two periods of economic and economists’ dysfunction.

In this context, the key difference between the rival theories is their differing approaches to supply and demand.

Neo-classical economics assumes the action is always on the supply side. Something called Say’s Law tells us supply creates its own demand, so get supply right and demand will look after itself.

The modern incarnation of this is “the three Ps”. In the end, economic growth is determined by the economy’s potential capacity to produce goods and services, and our “potential” growth rate is determined by the growth in population, participation and productivity improvement (with the last being the most important).

By contrast, Keynesianism is about fixing the problem Say’s Law says we can never have: deficient demand. Insufficient demand was what kept us trapped in the Depression. Keating argues the fundamental cause of our present stagnation is deficient demand, and the solution is to get demand moving again.

Back in the stagflation of the 1970s, however, the problem wasn’t deficient demand. It was the supply side of the economy’s inability to produce all the goods and services people were demanding, thus generating much inflation pressure.

After realising that Friedman’s targeting of the money supply didn’t work, the rich world’s eventual solution to the problem was what we in Australia called “micro-economic reform” – reduced protection and government regulation of industries, so as to increase competition within industries and spur greater productive efficiency and productivity improvement, thus increasing our rate of “potential” growth.

Keating – who, with another bloke of the same name, played a big part in making those early reforms – insists they worked well and left us with a more flexible, less inflation-prone economy. True.

By now, however, assuming you can fix a problem of deficient demand by chasing greater competition and improved productivity just shows you haven’t understood the deeper causes of the problem.

But when Keating advocates a new economic strategy of demand management, he doesn’t just mean governments borrowing and spending a lot of money now to give demand a short-term boost.

He mainly means a new kind of micro reform that, by increasing the income going to those likely to spend a higher proportion of it, and by lifting our education and training performance to help workers cope with new technology, ensures demand strengthens and stays strong in the years to come.